Investing in a downturn is Lombard Odier’s investment strategy

What is the forecast for the markets from the current level?

Key points

  • Recent history for the S&P 500 shows that the stock market’s decline, between peak and trough, is 35% during a recession and 19% outside of a recession.
  • Cyclical bear markets are less damaging to stocks than structural ones, but more painful than those caused by specific events.
  • We expect a recession in 2023, which is already factored into stock valuations and sentiment indicators. However, the situation may worsen in terms of earnings and capital outflows.
  • Our equity allocation is currently underweight as options strategies on major indices. We favor quality and value stocks, the UK and China markets, as well as the energy and healthcare sectors. We advise against any attempt at market timing.

Stock investors, broke, try to hide. The S&P 500 posted its worst first six-month performance since 1970. Most major equity markets have lost between 10% and 25% since the start of the year and are still in a downtrend, despite some recovery from the lows of May and June. Recession fears were amplified – and then overshadowed – by concerns about high inflation and the ongoing war in Ukraine, leading to a shift from cyclical stocks to defensive stocks and sectors. Investor sentiment has rarely been so negative. How could the coming downturn affect the markets and how much further could they fall? In this scenario, which stocks and regions, which sectors and styles should we prefer? And when will be the right time to buy on weakness?

What history teaches us

Recent bear episodes tell us about the extent and timing of the market pullback. The time elapsed between the highest and lowest levels gives us a rough estimate of this. Examining the fifteen corrections of more than 15% that the S&P 500 has experienced since 1960, we see that eight of them occurred during recessions, while the other seven did not (see Chart 1). In the first category, markets took an average of fourteen months to reach their lows, with average losses of 35.0% from their peak. In the second case, they needed only half the time, the average loss was 19.4%. In light of this, the S&P 500’s current 17% decline, which has stretched nearly seven months, suggests the market is divided about the likelihood of a recession. This suggests that if this happens, the markets could still lose around 10%-15%, and if not, they will soon bottom out. Further analysis suggests that a soft landing would correspond to roughly a 10% upside from current levels.

The situation is complicated by the fact that in the case of a recession, the duration of the fall in the stock market can be more or less long. Markets took more than two years to reach their lows in 2000, despite a mild recession, and more than a year and a half in 1980 and 1973, when recessions were by contrast notable. In 2020, it took them just over a month, despite a deep economic downturn. Typically, during a recession, Purchasing Managers’ Indexes (PMIs), which measure prevailing economic conditions, fall to about 30 points (knowing that anything below 50 points means contraction) and unemployment rises sharply. Market recoveries can be just as pronounced, but as with pullbacks, it takes longer to recover to previous peaks during recessions (average duration thirteen months) than during non-recession corrections (four months).

Thus, we can state that one of the determining factors for the amplitude and duration of bearish phases is the occurrence or not of a decline. On the other hand, the moment of their occurrence does not depend on them. Markets move predictably, usually peaking about six months before the “official” start of a recession (which can only be realized months later, in hindsight), and bottoming out before the recession ends.

By analyzing the type of bear market we are dealing with, we can learn more about the current correction. Structural bear markets stem from underlying economic imbalances, such as the housing bubble that burst in 2008 or the boom in technology valuations and general stocks that collapsed in 2000. Among those we studied, these two examples were the longest. and the most painful. Cyclical bear markets reflect a more classic boom/bust cycle, usually triggered or interrupted by rate hikes. Event-related downturns follow one-off large shocks, whether or not they lead to a recession. Take, for example, the COVID-19 pandemic. During the recession, it is usually short but painful. From our perspective, we are currently in a cyclical bear market, with no major imbalances to correct. The average maximum loss in this configuration is 29.3% over an average duration of 21.6 months.

Where are we in the current cycle?

Does a downturn seem inevitable and where are we in the current cycle? It seems almost certain that future hikes in the United States in July and September will push rates to levels that could actively dampen future growth. While retail sales continue to rise, U.S. consumer confidence is at an all-time low, and soaring prices will force more households to spend more of their budgets on essentials. Our own global economic indicator, which typically leads global GDP by six to eight months, recently shifted from slowing to contracting, signaling the start of a recession in the first quarter of 2023. Our central scenario, which suggests a mild recession in 2023, is now the consensus among economists, according to a Financial Times poll.

Given rising expectations of a recession and rising interest rates, the decline in equity valuation multiples is already consistent with past recessionary episodes (see Chart 2). And yet, given particularly high starting points, recent declines have only returned multiples to the average levels that have historically prevailed at stock market peaks. Under these conditions, it seems unlikely to us that they will rise again before inflation reaches a decisive peak in the United States. Indicators of investor confidence also reflect pessimism, matching previous lows. This is clearly demonstrated in the latest global survey of fund managers conducted by Bank of America. Additionally, mega-caps such as Goldman Sachs and Meta Platforms are set to slow hiring and/or firing, also a sign of contraction.

Benefits: A storm we haven’t seen yet?

The profits themselves do not cause concern yet. Analysts expect earnings per share (EPS) to rise by an average of 5.6% in the second quarter, the results of which are published. A healthy indicator, but it is largely related to the preemption of energy companies. Earnings continue to benefit from steady GDP growth and high commodity prices. However, as activity slows and prices rise, this situation should worsen. In our view, consensus EPS growth estimates of 10% growth in the third and fourth quarters do not reflect this. In fact, analysts still believe companies will be able to expand their earnings and margins in 2023. While earnings typically continue to rise during market downturns that aren’t accompanied by recessions, earnings per share fell an average of 17%. retrospective and prospective measures. Any disappointment in second-quarter results – or, more likely, in the forecasts reported by company executives – will be closely scrutinized and could lead to further declines in markets.

At the same time, we haven’t seen any signs of the kind of investor “capitulation” that usually heralds market bottoms – in other words, a rapid and widespread sell-off in stocks and a sharp increase in trading volume. In equity markets, capital outflows have certainly accelerated, with the sell-off more pronounced in the high-yield credit segment than in the equity segment. However, panic movement does not seem inevitable to us.

Equity allocation positioning

In this extremely uncertain environment, and given the potential for upside as well as the sharp decline in the stock market, our equity positioning is slightly smaller when factoring in our option strategies on US and European indices. These strategies aim to partially protect investors from future losses. Of course, if the news flow improves, a tactical bounce from oversold levels remains possible. However, knowing that pessimism prevails, we will need more focus on the inflation/growth pair before becoming more constructive on equities.

Performance spreads are wide, so the micro-opportunities that come from stock picking remain attractive. In terms of style, we favor quality and value stocks, which tend to perform best during recessionary market corrections (while quality and growth stocks outperform during non-recessionary corrections). We prefer the energy and healthcare sectors, as well as the UK, US and China.

We also advise investors not to try to predict short-term market movements (market timing), as this strategy can be costly. In the markets, down days are often replaced by very positive days, and it is almost impossible to know when to position yourself effectively and systematically. For example, over the past seven decades, investors who missed the S&P 500’s ten best days sacrificed an average of 63% of their performance over the decade (see Chart 3). If we miss both the best and worst sessions, overall the impact will be negligible, even negative when transaction fees are factored in. Therefore, we recommend a diversified and long-term investment strategy for both stocks and other asset classes.